Question

Explain the financial factors that can be used to determine the quantum of retention funding that can be absorbed by the enterprise.

Answer 1

In the question, retention of risk is being talked about, i.e, how much risk a firm can retain or absorb, by paying it out from whatever funds that are available.

Factors that can be used to determine the quantum of retention funding that can be absorbed by the enterprise are:

1. Sales projections: estimate of sales determine the amount of revenue and profit the firm will earn. Also it determines the amount of bad debts that can incur. If the sales projection is made accurate, chances of of bad debts and other risks are reduced and thereby increasing the profit.
2. Cash flow requirements: business needs cash to run the business. Cash is required both for long term purpose and also for the day-to-day operations of the business. The availability of the amount of cash determines the the amount of risk a firm can absorb. Excess cash is kept as reserve to meet uncertainty in business environment.
3. Shareholder's profit expectations: profit earned by the firm in a particular time period is either distributed as dividend to the shareholder and/or kept in the reserve. Shareholders expect dividend for the risk taken by them. Their level of expectation determine the amount that will be kept in reserve which in turn will determine the amount of risk the firm can absorb from the available funds.
4. Loan covenants: loan covenants are the legal binding clauses set out in a contract, which if breached, will lead to legal and compensatory actions. In an affirmative covenants, borrower is expected to perform several actions, like to maintain the level of insurance, which will determine the quantum of retention funding.
5. Availability of insurance: In risk retention, firm can either plan in advance and made arrangements for the losses that might incur, or it can wait for the losses to incur and then pay for it. Firm can get it funded through an insurer. But the amount of funding depends on the availability of the insurer and the amount of insurance taken.

There can be other factors as well, like the legal and the accounting tax positions, etc.